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Government Bonds

Developed Markets government bonds

In 2018, we expect long-term rates to rise in the US and Germany by more than currently indicated by the forwards. One argument behind this view is that the support of Central Banks’ quantitative easing1 policies will definitely be less intense than was previously the case, as the ECB will purchase fewer sovereign bonds than in 2015-17 and the Fed will not reinvest $252bn of US Treasury securities in 2018 (and around $360bn in 2019). While the net issuance of long-term eurozone sovereign bonds after ECB purchases has been negative at around €500bn in 2017, this quantity should only account for approximately -€60bn in 2018..

As far as the slope of the yield curve is concerned, we have two distinct views, as we expect the curve to steepen in Germany and flatten in the US.

A continuation of the steepening trend in the German curve (in the 2Y-10Y segment) is supported by the following:

• The Bundesbank continuing to purchase relatively short maturities;
• The Eurosystem’s holdings of German securities, considered in 10Y equivalents, which are expected to stagnate or even fall in 2018 (depending on the timing of Public Sector Purchase Programme (PSPP) reinvestments and the share of the PSPP within QE in 2018);
• EUR short-term rates remaining broadly anchored by the ECB’s forward guidance and not expected to be driven up by rate hike expectations during the first half of 2018 at least;• Despite the ECB’s reasserted forward guidance, expectations of some build-up on term premiums as the ECB is gradually engaging in policy normalisation and inflation is expected to increase gradually.

Our target for the 2Y rate is in a -0.40% to -0.20% range, with the 10Y rate at 1% by the end of 2018. The US yield curve is expected to flatten (particularly in the 5Y-30Y segments) as:
• The front end looks more likely to sell off than the back end, as the Fed is expected to hike at least twice in 2018;
• US 2Y-10Y could potentially flatten further from current levels; if some form of fiscal relief is delivered, with
a boost to growth and inflation, the Fed could consider hiking a third time in 2018, overcompensating for any
lift in the 10Y segment;• Historically, the yield curve has flattened during Fed rate hike cycles.

Our targets see the 2Y rate at 2.10% and the 10Y rate at 2.70% by the end of 2018.

For Europe, we generally have a broadly positive view of peripheral bonds, as the ECB’s PSPP will remain very supportive. On top of the still-significant Eurosystem bond purchases, the increasing deviations from the capital key rule will benefit French, Italian, Belgian and Austrian bonds more and more, and the maturity of Eurosystem purchases will remain higher for peripherals than for the purchases of German securities. Another argument in favour of peripherals is the cycle of re-rating of these countries (very recently, Italy and Portugal were upgraded by S&P and Ireland by Moody’s). Regarding this segment, political risk remains the key issue: in particular, the Italian general elections will have to be monitored closely and may cause temporary widening of sovereign spreads. That said, the approval of the new electoral law is lowering the risk of a M5S-led government, as the electoral system has become more proportional and should favour the formation of coalitions, which M5S is completely against.

We have a constructive view on inflation-linked bonds in Europe. We expect eurozone inflation break-even rates to “normalise” in 2018, as they are currently still at very depressed levels (the German 10Y break-even rate is still below 1.30%) and as we are relatively confident about the gradual rise in core inflation in the eurozone. On the other hand, while US inflation break-even rates are not far from fair value (which we see at around 2%), they represent an interesting hedge in case of an unexpected acceleration in inflation.

UK: we do not believe that the BoE can really afford to pursue a real rate tightening cycle in 2018 and therefore we expect short-term rates to remain close to their current level. We have no strong conviction with regard to longerterm rates, although the expectation of weakening pressure on the GBP should keep inflation expectations quite elevated and, to a lesser extent, put pressure on the back end of the curve.

Japan: although we expect the BoJ to remain highly accommodative, the central bank might have to increase the current yield target on 10Y bonds slightly from the current 0% to around 0.10% in order to move gradually closer to the level of global yields.

In 2018, we expect the global macro environment to remain relatively carry friendly, supporting EM bonds. Improving fundamentals and limited downside from China and commodity price stability are expected to keep global volatility subdued. Despite the current widening in spreads, valuations in the EM hard currency space still look tighter based on fundamental factors. Moving into 2018, we expect spreads to widen further due to rising US rates and EM-DM growth differentials. We believe investors should prefer a relative value approach at the single country level, favouring countries with improving fundamentals, a credible reform agenda (Argentina, Egypt, Brazil), attractive valuations, and attractive risk-adjusted carry. We are not expecting massive capital outflows from EM hard-currency bonds even if DM central banks continue to tighten monetary policies and although the positioning in EM hard currency bonds seems a bit stretched. In addition, we see risks of aggressive Fed tightening and a significant fall in commodity prices as relatively low.

Emerging debt, local currency

Given our cautious view on EM currencies in 2018 (see the FX outlook), we have a neutral view on EM local currency debt, with an increased focus on selection. Our EM real rates model (GBI-EM global-weighted2) shows limited room for manoeuvre, as inflation in EM is likely to remain within the central banks targets (see chart below). EM FX valuations show limited upside over a 12-month horizon. We believe investors should focus on countries where sensitivity is low to the US 10Y yield in an environment in which US rates are increasing. Based on our analysis of the external vulnerability4 index of EM countries, we prefer countries with low external imbalances. However, we think it is worth noting that ince the first Fed tapering in 2013, most EMs (except Turkey) have adjusted their external balance sheets and, as a result of these adjustments, we might not see significant underperformance if US rates continue to rise in an ordinary manner.

Overall, we expect EM hard currency bonds to continue to outperform local currency bonds in 2018 in terms of spread compression. EM domestic fundamentals remain strong, attracting additional inflows, and the bulk of the underperformance of local currency bonds is expected to come from local currency depreciation, due to countryspecific idiosyncratic event risks. Between the two asset classes (HC or LC), our preference remains towards high carry countries with improving fundamentals (growth, prudent monetary policies, and strong reform agendas), such as Argentina and Brazil.

1. Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate an economy by buying financial assets fromcommercial banks and other financial institutions.

2. GBI-EM Global Div is the most widely used index in the JPM EM Local Markets family.

Credit Markets

The dollar and euro credit markets recorded another year of very good performances, as follows: US IG (2.9% excess return vs government bonds, Euro IG (3.3%), US HY (4.8%) and Euro HY (7.2%). These positive performances have been supported by a broadly synchronised upswing in the world economy, highly accommodative monetary policies, andvery low volatility. We believe that the credit markets will continue to benefit from this environment in 2018: global growth is positively oriented and the moderate inflation outlook is enabling the ECB and the Fed to gradually tighten their monetary policies. On the back of this rally, spreads are closing in on cycle lows, so the key question for investor is “what should we expect for 2018?”

Technical factors will remain supportive for credit markets

In our view, the US IG market will continue to be supported by the following:

• Strong inflows. The demand from foreign investors has increased at an unprecedented pace in recent years. USD corporate securities held by foreign residents have increased by 45% since 2012 and currently account for 40% of the USD corporate bond market.

• The slowdown in net supply, after the peak reached in 2015 thanks to the recent decline in M&A and share buyback activity. American companies raised a record amount on the US IG market primarily to fund M&A and share buybacks. This market has virtually doubled in size since the collapse of Lehman Brothers.

US HY offers a different picture: market flows are relatively flat on an YTD basis, but the net supply has been negative over the past two years. Companies prefer to borrow on the loan market, as covenants have weakened. This trend is expected to continue in 2018.

The Euro market will continue to be sustained by the following:

• The search for yield. The ECB will likely continue to keep sovereign interest rates under pressure in 2018 (negative net sovereign debt issuance after ECB purchases and rates will remain at their present levels for an extended period of time, in our view). The IG and HY markets should both benefit from this search for yield.

• The “sizeable amounts” of ECB purchases. Indeed, the ECB faces no scarcity issues on the corporate bond market, as could be the case on the sovereign and covered bond markets. Corporate Sector Purchasing Programme (CSPP) holdings amounted to €114bn at the end of September 2017, which represented only 13% of the universe of bonds eligible for the CSPP. We expect the ECB to purchase corporate bonds at a monthly pace of €3.5-4bn from January 2018 until the end of September 2018.

• Negative net supply on the Euro HY market also offers support for spreads. As in the US, the loan market is cannibalising some issuance on the high-yield bond side. This trend is expected to continue in 2018.

Fundamentals are well oriented

The fundamentals of American companies should continue to improve in 2018. Most companies recorded a decline/ stabilisation of their leverage in recent quarters due to:

• A positive trend in profit growth. Sales growth was supported by positive global economic momentum, the recovery in the price of oil, and the good performance of the technology sector;

• More cautious behaviour, which is quite unusual at this stage of the cycle.

• However, the number of HY firms with very low interest coverage ratios remains high. Currently, one-third of companies seem to be in a challenging situation.

The fundamentals of European companies should remain in line with bondholders’ interests. European companies globally have low debt. The recent acceleration of European growth has not led to massive M&A, share buybacks or large dividends.

Companies are in general fairly relaxed about their funding needs. Companies pushed the redemption wall out further as they increased their debt maturity profiles. US HY and Euro HY default rates are expected to fall further in the coming months. In particular, speculative-grade default rates should decrease to the 2.5-3.0% area in the US, while European default rates are expected to fall even more from already low levels to the 1.5-2.0% range.

On the back of the last rally, valuations appear tight

Our models show that although valuations look rich vs their underlying factors on both sides of the Atlantic, US credit spreads look more stretched than for EUR credit markets for both IG and HY, despite the ECB’s direct support for European credit through the CSPP. Current yield and spread levels point to lower expected returns in the coming years (but this is a common theme throughout the fixed income world).

In terms of curve segments and sectors, we still prefer the few remaining “oases” in the European yield desert, especially in the 1-5-year segment of European yield curves: IG financial subordinated debt and speculative-grade debt, within this segment, remain almost the only suppliers of still positive, though limited levels of yield, therefore attracting investor flows over the next quarters.

While European credit markets – which are under the CSPP “umbrella” – offer an attractive risk/reward combination, especially in terms of lower volatility with respect to the past, US IG bonds, despite being relatively expensive in terms of valuations, offer quite an attractive absolute yield level in fixed income and balanced multi-currency portfolios.

Within the HY universe, low-rated segments also look stretched in terms of the implied default rate. High- quality (BB-rated) HY spreads, on the other hand, still provide a bit of a cushion for credit events in both USD- and EURdenominated debt: in the current low default rate environment (low yield, low growth, low inflation), BB-rated spreads still imply a default rate higher than historical long-term averages.

FX Markets

EUR/USD

The continuation of a solid recovery in the eurozone paired with diminishing monetary accommodation from the ECB provides a positive backdrop for the single currency into 2018. Although its valuation gap with the USD narrowed over 2017, the EUR is still cheap versus the USD, providing fundamental support. The reduction we expect for the 10Y rate differential between the US and Germany should cut the attractiveness of the USD versus the EUR on a carry basis. The upside potential to EUR/USD rate should, however, be limited by both the dovish quantitative easing recalibration by the ECB for 2018 and the prospect of a tax cut in the US.

The political agenda for 2018 is much lighter than 2017. Risks are concentrated around general elections in Italy by the first half, regarding which we could see long EUR positions being hedged ahead of the event.

On the positioning side, we believe this year’s real money investors’ shift from the USD into the EUR could remain in place, as an overall accommodative monetary policy stance should keep investors’ risk appetites upbeat and favour the continuation of flows into European equities, thus offering the EUR an additional tailwind.

Our target for the EUR/USD rate in H1 2018 is 1.15-1.18. In H2 2018, we could see appreciation of the EUR versus the USD towards 1.22.

USD/JPY

Monetary policy will continue to be supportive for FX, as the BoJ is expected to remain very accommodative in 2018. The JPY has scope for further depreciation, in our view, both versus the USD and the EUR, due to gradually rising long-term yields in the US and in Europe versus 10-year yield targets maintained at around 0% (as per the BoJ’s “Yield Curve Control”). Rate differentials will therefore remain the main driver of the exchange rate. However, we do not believe that the JPY can depreciate too much, as on the one hand, the currency is already sharply undervalued and, on the other, a substantial rise in global interest rates might prompt a reaction from the BoJ, which could have to raise the 10Yr yield target as a consequence. Approaching 120 for the USD/ JPY would, moreover, exacerbate accusations of currency manipulation from trade partners.

Positioning on the JPY from institutional investors has been skewed to the short side during 2017, and barring any spike in geopolitical risk or material changes to the BoJ’s stance, it is likely to remain in the current bearish range.

Our target for the USD/JPY rate is in the 115-118 range by the end of 2018.

GBP/USD

Our expectations regarding the UK economy are for an extended GDP weakness into 2018 on the back of the uncertainty over Brexit negotiations, weighing mostly on investments. In such a fragile backdrop, we believe the BoE will struggle to hike rates further in 2018. News flow on Brexit negotiations remains crucial and the GBP will likely be quite volatile and trending lower, versus both the USD and the EUR. Risks are related to a benign scenario in discussions with the EU: the achievement of a transition agreement would in fact postpone the materialisation of any impacts for the UK due to its departure from the EU.

Our target for the GBP/USD rate is in a 1.26-1.28 range by the end of 2018.

EM FX

A supportive global backdrop for EM FX was in place for most of 2017, as a strong rebound in global trade, benign global rates, positive growth surprises from China, and a weaker USD helped EM FX to outperform until the summer. However, since September, these tailwinds have been fading and, looking forward to 2018, we have a more cautious view on EM FX as an asset class.

We expect the USD to remain broadly weak, but not to depreciate to the same extent we were expecting at the beginning of 2017. EM-DM growth differentials are expected to flatten out or marginally increase into 2018, as the global growth acceleration is shifting from China to DM or to other EM. Incremental EM export volumes are cooling after extremely strong growth in Q1 2017 (base effect). We do not expect a significant commodity price rally to drive EM FX next year.

This is a key component to capital flows into EM. The differences between local and DM rates are expected to narrow, supporting hard currencies.

From the perspectives of EM central banks, we expect less of an easing bias in 2018. Based on our Taylor Rule1 and macro assessment, we expect EM rates for 2018 to be determined mostly by output gaps, not by inflation gaps, as inflation in most EM (except Turkey) is likely to stay within central banks’ targets. Moreover, we expect EM central banks to continue to accumulate FX reserves at least to 2013 pre-taper levels as EM inflation (broadly) should remain low and within CB targets. Lastly, uncertainty regarding US tax reforms and risks from rising US rates could represent key triggers for an EM FX sell-off, and the busy political calendar in many EM will add more volatility in 2018.

Notwithstanding these issues, there is still room for being selective on EM currencies, with a focus on highyielding EM FX, where carry is still attractive. Short-term valuations look a bit stretched, according to our valuation models, but on a medium-term basis, there should still be enough room for selective EM FX to appreciate. We continue to prefer relatively cheaper high carry/low volatility currencies of the less externally vulnerable countries, such as the Indian rupee and South Korean won.